In today's capital markets, securities seldom lie idle. If not being bought and sold in outright market transactions, securities are frequently lent to parties wanting to borrow them, or used as collateral to raise short-term finance. These transactions include repurchase agreements, securities loans and sell-buyback agreements. While they differ in detail, they nonetheless have many similarities. This family of transactions is generically described as “securities lending”.
Securities lending transactions generally involve the simultaneous or near-simultaneous transfer of securities for collateral. Significant securities lenders include entities such as banks, investment managers, pension funds, mutual fund complexes, endowment funds, and insurance companies. Lenders often lend securities to supplement or earn incremental income on their portfolio holdings. Borrowers are generally broker/dealers and banks. Borrowers often borrow securities to facilitate trade settlements, and to support both proprietary and customer trading strategies.
Participants in securities borrowing and lending transactions can be further sub-classified into: Beneficial Owners; Agent Lenders; Broker/Dealers; and External Customers. Beneficial Owners are the true owners of securities. Agent Lenders are often banks that custody the shares of the beneficial owners and represent the beneficial owners in securities lending transaction. Agent lenders often represent more than one beneficial owner, thus creating an aggregate pool of securities to lend. Agent lenders generally provide administrative services to the beneficial owners such as reporting, corporate actions monitoring, collateral management, and billing. Broker/Dealers often have securities borrowing and lending trading desks that coordinate the borrowing of securities from lenders to cover customer and proprietary trading needs such as arbitraging, hedging and short selling. Broker/dealers may also borrow securities to settle transactions that are failing, or to lend them to other broker/dealers.
Securities lending has become a central part of securities market activity in recent years, to a point where the daily volume of securities transactions for financing purposes considerably exceeds that of outright purchase and sale transactions. Securities lending involves the temporary exchange of securities, usually for other securities or cash of an equivalent value (or occasionally a mixture of cash and securities), with an obligation to redeliver a like quantity of the same securities at a future date. Most securities lending is structured to give the borrower legal title to the securities for the life of the transaction, even though, economically, the terms are more akin to a loan. The borrow fee is generally agreed in advance and the lender has contractual rights similar to beneficial ownership of the securities, with rights to receive the equivalent of all interest payments or dividends and to have equivalent securities returned. The importance of the transfer of legal title is twofold. First, it allows the borrower to deliver the securities onward, for example in another securities loan or to settle an outright trade. Second, it means that the lender usually receives value in exchange for the disposition of legal title (whether in cash or securities), which ensures that the loan is collateralized.
In a typical securities lending transaction, a stock or bond is exchanged for collateral between a lender and a borrower for temporary use. Generally, the lender through its lending agent delivers a security to an approved borrower in return for collateral, usually in the form of cash, U.S. Government securities, letters of credit, or other selective forms of non-cash collateral. In most instances, the borrower is a broker/dealer who uses the securities to meet an array of short-term needs, including: avoiding settlement failures, supporting hedging-short selling strategies, and to facilitate arbitrage opportunities.
Collateral is a key element in a securities lending transaction. For use of a security, a borrower provides collateral to the lending agent to secure the borrower's promise to return the security within an agreed upon timeframe. Generally, the collateral requirement for domestic loans is 102% and 105% for international loans. The excess collateral serves as a safeguard against counterparty credit risk in the event of a borrower default, which could necessitate the collateral being liquidated and repurchasing the loaned security. Monitoring the collateral adequacy, known as performing a “mark to market,” occurs daily. Should the collateral fall below 100% of its market value, additional collateral is requested from the borrower to restore the value to its appropriate level.
The lending agent agrees to pay interest, known as the rebate, to the borrower for the use of the cash collateral. The amount of the rebate reflects the intrinsic value of the loaned security-keeping in mind that some securities are more highly sought after than others. The higher the demand is for the security, the lower the rebate that will need to be paid. The cash collateral is then invested by the lending agent in accordance with the lender's investment guidelines. The goal is to earn a higher yield on the reinvestment of cash collateral than the rebate promised to the borrower. The earnings generated above and beyond the rebate amount, referred to as the “spread,” represents the profit in the transaction. In a non-cash collateralized lending transaction, the borrower and lender negotiate a premium (or a flat fee) to be paid in place of the rebate.
Currently, there are two primary ways in which the securities lending operations are transacted. First, manual transactions are done by traders and other personnel of lending and borrowing entities communicating by traditional avenues such as phone, fax or email. This process is inherently ineffective and prone to human and other errors which result in the creation of inconsistent data or other discrepancies or even in failed trades. Second, point-to-point connections permit an entity that intends to either borrow or lend securities to set up a connection with a counterparty and communicate with that party using a pre-determined protocol. This will result in a plethora of protocols and sometimes even technology platforms and infrastructures that a firm ends up building and supporting. This creates a technology environment that is very expensive and cumbersome to maintain, eventually working to the detriment of the organization in most cases.
Due to the aforementioned peculiarities of securities lending transactions, present electronic systems for carrying out securities and commodity trades have proven inadequate. One such system used, for example, for over-the-counter trades is the Instinet system, as is described in U.S. Pat. No. 3,573,747. The Instinet system includes a series of terminals, each accessible to a member and a central computer. Each member may submit for display a firm offer to buy or sell a given number of shares of a certain security at a stated price. The member may also submit bids or offers of a security without price. This information, minus the submitter's identity, is displayed to all members, in a price sequence. Any member may respond to an offer through the negotiating option of a counteroffer and the system will allow private communications between the two members until and if an agreed upon price is reached. Alternatively, a member may submit an acceptance of any offer displayed to all members. In either option, the system executes orders when a buyer and seller have agreed upon a price. The parties to an executed trade deliver the shares of stock and purchase price to a designated bank for a conventional clearing operation. If a bid and an ask are submitted at the same price, the system will consummate the trade.
The Instinet system is not designed to address the unique aspects of securities lending. The Instinet system does not provide potential borrowers or lenders the ability to transmit, in real-time, their availability and parameters for a desired transaction, making the process of matching amenable counterparties time-consuming and labor-intensive, especially when the parties reside in disparate geographic locations, due to time-zone differences. It would, therefore, be advantageous to provide a system that allows parties to broadcast availability messages in real-time, to facilitate the identification of suitable counterparties.
Unlike traditional securities transaction such as the sale/purchase of stocks, bonds, etc., stock loan transactions remain “open” after the initial transaction is completed, i.e., the loan of stock for use as collateral in a financial transaction. It is, therefore, desirable to have a system that would allow the users to program business rules into their own proprietary system to trigger the generation of autoborrow and availability messages, based on a set of parameters such as the positions or requirements of specific securities, to allow for the recall and return of loaned securities, mark-to-market comparisons, and other features specific to the field of stock loan (i.e., securities lending) transactions. As well, it would be desirable to have a system that operates using an open protocol, to allow system users to integrate their systems, whether proprietary or otherwise, into the system in real-time.
Further, it is desirable to have a system in which availability broadcasts could include the available party's desired transaction criteria. The system would, optimally, permit the available party to tailor the broadcast to include specific, desired transaction terms and enable the initiation of orders that targets all available counterparties using a single messaging protocol.
Moreover, as previously mentioned, prior art systems cannot adequately address the needs of those engaged in securities lending transactions. As opposed to outright sale and purchase of securities, a securities lending contract remains open for a significant period of time. Hence a system that intends to facilitate securities lending should store these transactions for a much longer period, than that is required for the regular trading of equities. The metrics associated with the loan contracts need to be periodically compared and reconciled (in the novel system described hereinafter, it is accomplished through contract compare, mark-to-market and billing compare). Accordingly, it is desirable to have system that facilitates securities lending that provides the ‘recall’ feature to the lenders to recall securities that they have lent and ‘return’ feature to it's borrowers to return the securities recalled.